With OSC hearings underway for the Sino-Forest fiasco, I thought it time to think about the lessons it and similar investor frauds teach us.
Curious what one of these frauds looks like? Read this press release and ask yourself, how did this company ever get listed? What on earth were the auditors, underwriters, Exchange, regulators, directors and all their respective legal counsel doing?
To re-cap, Sino-Forest was a TSX-listed, Chinese forestry company. It rose rapidly in stock price and value to a market cap exceeding $6B CDN, through with many secondary offerings of debt and equity after the initial public offering. Ultimately, it was shown to be an utter fraud and it collapsed in bankruptcy. Interestingly, it was by no means an anomaly – it was one of many similar North American – listed publicly traded Chinese frauds. In my case, I avoided Sino-Forest which I thought was a an obvious fraud, and in turn was sucked in by one called Zungui Haixi, which supposedly made and sold running shoes.
Sino-Forest may have been a Chinese forestry company, but its consequences for all companies needing to raise risk capital in Canada are real – and the lessons it teaches about the importance of trust, and how quickly trust can be squandered, are real for all participants in the capital markets (and thus are very important for innovators and entrepreneurs).
The most obvious lesson to be drawn from Sino-Forest et al is “never rely on auditors or audited financials”. That is a valuable lesson to be reminded of, and not just in the case of outright fraud. On Sino-Forest, as on Zungui Huixa, and on many others, the work done by the auditors (E&Y in this case) was totally, utterly substandard, but even in normal times, audited statements are at best a professional opinion bought by the issuer. Issuers then waive this opinion in front of investors, but wise investors don’t actually give the opinion much weight and certainly do not rely on it. In one of the few recent Supreme Court of Canada cases that I think was absolutely wrongly decided, Hercules Management, the SCC agreed with the accounting lobby and insulated auditors from the vast majority of lawsuits from shareholders. In short, in Canada, investors cannot normally sue auditors even if the financial statements are wrong and misleading. As a result, the only prudent course for an investor is to assume that audited statements are just another piece of issuer-bought marketing puff.
But the brutal truth of these cross-listed frauds is that absolutely no one in the investment eco-system is devoid of blame, and most of these failings were caused pure and simple by greed (the hunt for fees, and the hunt for returns). The auditors are the easiest target, but everyone dropped the ball in some way:
– the underwriters and their legal counsel. They were happy to take big fees for each offering, and doubtless charged hefty fees for due diligence and still failed to uncover a blatant fraud.
– the investment banks and their “analysts” who all had “Buy” recommendations on the stock. Of course, recommendations from analysts who work for sell-side investment banks are worse than useless – Sino-Forest was just a reminder of the obvious. Sell-side analysts fill a marketing function for investment banks, and their recommendations are no more valuable to an investor than a beer commercial is to a beer drinker. Put another way, if sell-side analysts knew anything about investing, they would not be sell-side analysts they would be investors.
– management and directors, especially directors who did not speak Chinese who agreed to try to perform a role they were not fit to fill (supervision of a company whose operations, an ocean away, were conducted in a language they do not understand)
– the stock exchanges (in this case the TSX, but across the border the NASDAQ and NYSE), who completely failed to protect investors by enforcing real listing standards. Exchanges hungry for listing fees lowered their standards and chased listings, and anyone who thinks that the TSX was not partly to blame for the Sino-Forest disaster is being far too kind to them.
– the regulators, in this case the OSC and in the US the SEC. Permitting a company with no nexus to Canada, with no assets in Canada, with management with no assets in Canada, to offer securities to the public in Canada is at best naive, and probably stupid. Regulations without realistic sanctions are just wishes – and the cold brutal truth is that a regulator who does not have the ability to enforce its orders with real consequences (by stripping people of assets and putting people in jail) is an impotent enabler of fraud and has abandoned its duty to regulate. The OSC’s ‘remedy’ in the Zungui case would be laughable if it were not so useless – the OSC imposed a cease trade order, which hurt domestic investors and prevented them from even crystalizing their losses for tax purposes, but had absolutely no real negative consequences for the fraudsters in China who had long ago looted the treasury.
– investors. Investors chasing returns to good to be true ultimately bear the most responsibility. Greed kills, and investors (myself included) really have no one to blame but themselves for letting greed cloud their judgment.
The first and most important rule of investing is Caveat Investor: “investor beware“. Just like in boxing – you must protect yourself at all times, and you cannot count on anyone else to do it for you.
Of course, what makes investing so fascinating and challenging is that you must “beware, but take risk; trust but verify”. You cannot invest without taking some risk. Risk-free investing does not exist, and risk-free saving without investing just does not cut it. By the same token, however, trust is the bedrock for investing – without some trust in the behaviour of other participants in the system investors cannot invest, the cost of capital skyrockets, and innovators are starved of capital. For the capital markets to function, for innovators and entrepreneurs to access risk capital, investors must take risk and investors must trust – while being sceptical, prudent, and careful, protecting themselves and trusting no one too much.
Squaring that circle is what makes investing (and regulating the securities business) so difficult, and so much fun.